When your clients roll over a retirement account into an annuity, stay alert. They could lose significant tax benefits if they don’t document their investment in the contract.
Gains realized on surrender of an annuity are taxed as ordinary income, but the entire amount received on surrender might not be taxed, since a taxpayer is entitled to receive his or her investment in the contract back tax-free.
Keeping track of investment in the contract is simple enough when a person pays premiums out a checking account into the annuity—the total amount of the premiums will constitute investment in the contract. But when a rollover is made from a pre-tax retirement account like an IRA, things get more complicated, and documenting investment in the contract is essential to preserve its tax benefit.
The Tax Court recently considered whether a taxpayer was entitled to exclude the amount received on surrender of an annuity from gross income where the taxpayer failed to document his investment in the contract as funds moved between an employer savings plan, an IRA and into an annuity, James D. and Bobbie Rogers v. Commissioner, No. 25365-09S (2011).
James Rogers was employed by Lockheed Martin, where he participated in an employer-sponsored savings plan. He contributed 8% of his after-tax salary into the savings plan. Lockheed also made contributions to the plan. Rogers retired in 2003 and the funds in the plan were transferred to a money market fund.
Later that year, Rogers withdrew $16,000 from the money market fund, leaving a balance of $71,995. He then rolled the remaining funds into an annuity—the rollover was characterized as an IRA rollover.
Rogers made a series of withdrawals from the annuity, including a $7,000 withdrawal in 2004, a $5,000 withdrawal in 2005, $6,500 in withdrawals in 2006, and $10,000 in 2007. He surrendered the annuity in 2008, receiving $59,231 in 2008.
The Tax Returns
The 1099-R forms James Rogers received in 2004, 2005, and 2006 indicated that federal and state income taxes were withheld at the time of the withdrawals. But his 2007 Form 1099-R showed that he had elected not to have federal or state income tax withheld from the $10,000 withdrawal. Although the Rogers filed a joint return for 2007, they did not report the $10,000 withdrawal, and the IRS determined that the $10,000 withdrawal should have been included in gross income and issued a notice of deficiency, saying that the couple owed an additional $1,500.